From the archives: 2015-11-13 10:05:42
First a little background on what the interest rate actually is. The Interest rate means slightly different things depending on which country you are talking about. I’ll only deal with Canada and the USA since that is where my financial interests lay.
The Bank Rate in Canada is the rate at which the Bank of Canada lends funds to financial institutions. It is set at 0.25 per cent above the target for the overnight rate, which is the Bank’s key policy rate. The target for the overnight rate is the average interest rate that the Bank wants to see in the marketplace for one-day (or “overnight”) loans between financial institutions. Changes in this rate influence other interest rates, such as those for consumer loans and mortgages. This overnight rate is updated 8 times a year. In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an un-collateralized basis. The federal funds target rate is determined by a meeting of the members of the Federal Open Market Committee which normally occurs eight times a year about seven weeks apart. The committee may also hold additional meetings and implement target rate changes outside of its normal schedule. The Federal Reserve uses open market operations to influence the supply of money in the U.S. Economy to make the federal funds effective rate follow the federal funds target rate. In other words, both the US and Canada change the main rate used for overnight loans between banks, based on economic factors such as inflation, markets, employment, cash supply, and exchange rates etc. Theoretically speaking lower the interest rate, the lower the banks charge interest on loans, which is hoped to have an impact on the economy by consumers borrowing more money and spending more, resulting in more houses and iphones being made, resulting in more jobs etc etc etc…. “Economics 101 argues that low rates cause economic growth because consumers take advantage of them to finance home purchases; businesses, to build factories and hire workers. Consequently, the economy should grow faster: low rates stimulate the economy. ”1
Except, that’s not what really happens… Anytime, anyone, borrows money with interest, your return is less then you get at the beginning. Conduct the following mental experiment, borrow some money from our imagination bank at a really low interest rate of 1% and since the interest rate is so low you decide to borrow $1 million dollar for 50 years. Your payments per month would then be $2,119 a month and assuming you didn’t miss a payment, or the interest rate didn’t change in 50 years your total payback to the bank would be just over $1,270,000. Now if your smart, you look at theoretical loan in long terms right at the beginning. You start off in the hole $270,000. Borrowing the million dollars did not make you rich, what you do with it might, but right at the beginning you need to pull in over $2k a month just to make the payments. Now our imagination bank is offering the same deal to everyone, so everyone is equally in the same boat, all have a million dollars, all owe over the next 50 years, and all are going to have to make money with that first million to make ends meet…. “But if the real interest rate is low, the costs of living, doing business and investing are also low. This stimulates the economy because home and car loans are more affordable. If people can borrow more, they’ll spend more. Low real interest rates also generally weaken the dollar, which (in the short term) can be a good thing. When the dollar is weak, foreign goods are more expensive, so Americans tend to buy American-made goods. This stimulates the economy even further because high demand for American goods increases employment and wages . So why doesn’t the Fed simply keep nominal rates low? The problem is that this also leads to inflation. If a society’s demands for a certain good exceed the supply, then the product’s price will go up. When inflation increases, economic growth begins to slow. The price of the good increases, and so demand for it wanes. Less demand leads to less production, and eventually, unemployment ensues.”2
Money vs Wealth Again
Low interest rates do not create wealth, all it does is move money around. It can move wealth, remember; real wealth is not money, it’s stuff. By borrowing money you have a chance to move wealth from those who have it to yourself. But paying for that wealth will cost you more, and if the interest rates rise, it compounds the effect, making the cash value of that wealth less. And then there is a the big issue of low interest rates…. Both Canada and the USA use interest rates to set payments on bonds, and it also effects under-funded3 pensions. The lower the interest rate, the lower the payouts. As the Baby Boomers reach 25% of the population in North America, more workers between the ages of 18 and 65 are going to be needed to contribute to the pension plans, add in lower interest rates, and the number of workers needed increase exponentially4. Short term low interest rates can be a good thing, but long term low interest rates are a sign of something very wrong. What could these record low interest rates represent? What is it a sign of is the main important question, are low interest rate bad? I believe that they are not bad in of themselves, but what they point to, is something else. There are a combination of things to watch for to figure out if a change in the interest rate is something to worry about. First to watch is the length of time between changes itself, the longer it takes for the Fed or the bank of Canada to change the interest rate, the more cautious they are reacting to the current trends in the marketplace. Increasing the rate after a long period of time of low interest is a good sign, normally speaking. Lowering the rate is not.
Gold, Silver, and Copper
The other sign that things are not going well is price of metals. I’m not just talking about Gold5 and Silver, but also industry needed metals for production, such as copper6, if copper is low for a long time and is still dropping, production of end point products is falling and that means loss in profits, jobs, investment capital. All these take away from safety nets created by central banks. Yet more disturbing is the actual movement of wealth which can be measured by the Baltic Dry Index7, and the actual costs to move that wealth, lower costs means high competition and less real wealth in motion. SEA is a similar index to the Baltic Dry Index, but takes into account the movement of oil, to be honest I don’t trust it as an indication of the economy because of new projects such as keystone, and tilt that shale oil is giving the market right now.
Welfare, Unemployment, and hand outs
The last couple things to check on is the real employment rate, and the cost of living indexes. Unemployment rates can lie because they do not include the number of unemployed workers8 which have given up looking for work9, or the number of non-producers in the market (By non-producers I do not mean only those on welfare10 or pensions11, but also employees which only receive a paycheck because of tax funded grants12 etc13 another form of welfare that is not watch closely watched.). All these signs have been pointing to a total economic meltdown in so many ways it is easy to see that the worse is yet to come. The saddest part about all this is that non of this has anything to do with fiat money14, which is bad in itself, it’s just bad management on all fronts. So as it stands right now, low interest rates are bad news. But don’t worry the worse hasn’t happened…. yet.
Last Updated: Jan 23rd 2015